This piece extends a companion blog, providing additional analysis from a study I coauthored with Chris Hope (Judge Business School, University of Cambridge) in the Journal of Environmental Studies and Sciences. Here I focus on one of the implications of the analysis raised in the policy section of the paper: what do the different discount rates imply about how we view investments in cleaner sources of electricity generation?

I begin with a short overview of the article as summarized in the first blog, for review.

The article shows how global warming’s destructive impacts are being significantly underestimated by the U.S. government—because the government’s cost-benefit calculations vastly downplay impacts on future generations.

After valuing these future impacts more completely, we found that the real economic damages of letting climate change go unchecked are at least 2.6 to more than 12 times higher than the government’s main estimate.

The government’s approach matters a lot because its numbers are used to decide what actions should be taken now to fight climate disruption, such as the choice of what type of electric power we should build, which would change if more accurate estimates were used.

Power plants, vehicles, factories, and other pollution sources in the U.S. currently emit more than 7 billion tons of carbon dioxide (CO2) and other heat-trapping pollutants into the air each year. The federal government put the value of the damage caused by this pollution at $21 per ton of CO2. But we found that by properly accounting for the impacts to be felt by future generations, the damage estimate for each ton emitted (or, the benefit from each ton not emitted) is much higher, between $55 and $266 per ton. And even these estimates may be too low: they correspond to what might happen if future temperature increases are in the middle of scientists’ projections—not any of the worse-case scenarios they warn us about.

The government’s estimate is the product of an interagency committee established in 2009 to produce a uniform set of values for use by regulatory agencies, such as the Department of Transportation and the Environmental Protection Agency, in carrying out energy efficiency and environmental protection statutes relating to carbon pollution and climate change.

The difference in the government’s estimate and our own boils down to one factor: the “discount rate.” While it’s easy to get lost in economic jargon and the mathematics, here is what the discount rate does: it assumes that a dollar today is more valuable than one received in the future, hence when applied to anticipated damages resulting from climate change, it lowers the economic costs we assume will be inflicted on future generations.

The reasoning goes something like this: most of us would rather have a bird in the hand today than the same bird in the hand tomorrow. We are impatient and like instant gratification—even if it costs us something later. Sometimes that cost is income. This isn’t necessarily bad—we might expect to have more earnings in the future as we move up a career ladder, or to inherit money. Sometimes, however, it can be self-destructive; smoking, overeating, and failing to save enough for retirement are classic examples.

But what happens when you apply discounting to a problem where something benefits you today, but imposes much larger costs on your children and future generations? You might assume that your consumption today is more important than someone else’s in the future, and rationalize your actions by thinking that people in the future will be richer.

Our paper evaluates what kind of discount rates lead to this conclusion, and why. The companion blog summarizes the analysis; it includes a detailed discussion of discounting, our critique of the government’s rates, and the basis for our revised estimates using lower rates (the higher the assumed discount rate, the more future damages are discounted).

The value of clean energy investment: how much do pollution costs matter?

Below we compare the costs of building new generation with and without including pollution damages (using both our and the government’s estimates). These comparisons are in the published article for all technologies except natural gas and coal with carbon capture and storage (CCS), which I add here. I also extend the paper’s results to assessing the cost of continuing to operate plants in the existing coal fleet versus replacing them with cleaner generation.

In addition to the damages from CO2 pollution, the analysis includes impacts from the power sector’s sulfur dioxide (SO2) emissions which, every year, cause thousands of premature deaths, heart attacks and incidents of respiratory disease (e.g. asthma and bronchitis), millions of lost work and school days, and a variety of damages to ecosystems and property.

Seven types of electricity sources are examined: new conventional coal- and natural gas-fired power plants, new coal and natural gas plants equipped with carbon capture and storage technology (CCS), new onshore wind, new solar photovoltaic and, finally, existing coal generation. (Note that for the rest of this piece, I sometimes drop the term “conventional” before “natural gas” and “coal” when CCS technology is not included).

Overall, the analysis shows that if the well-being of future generations is properly taken into consideration, the benefits of cleaner electricity sources are greater than their upfront costs, both for new generation, and for replacing our dirtiest plants. In contrast, using the government’s estimate of CO2 damage costs tends to favor dirtier energy sources, and an ever riskier climate.

The next section below gives an overview of our results, followed by three sections that provide specific generation costs with and without pollution damages. Methods and assumptions are at the end.

Overview

The government’s analysis used discount rates of 2.5, 3 and 5 percent per year. In contrast, our study used 1, 1.5, and 2, in line with official guidelines from the Office of Management and Budget that permit lower discount rates (1 to 3 percent) when costs and benefits are intergenerational (p. 36, OMB Circular A-4 guidelines). For unexplained reasons, the government’s CO2 analysis did not extend the inter-generational discount rate below 2.5 percent.

At our two lowest discount rates (1 and 1.5 percent), we find that the real cost (i.e. generation costs inclusive of pollution damages) of building new electricity generation from natural gas (what the market currently favors) is higher than for wind or natural gas with CCS. At 1 percent, solar photovoltaic and coal with CCS would also be cheaper. These findings are driven by differences in climate change costs only, as SO2 pollution from coal with capture is small, and negligible for natural gas. When the government’s (higher) discount rates are used, conventional natural gas appears to be cheaper than these cleaner technologies.

I was surprised with my results for replacing existing generation: at all of our discount rates, it would be cheaper on average[1] to replace the coal fleet with cleaner sources than to continue operating it. The fleet emits so much CO2 (the power sector accounts for approximately 40 percent of U.S. CO2 pollution) that the avoided climate damages alone outweigh the apparent cost advantage of maintaining existing infrastructure.

At all of our discount rates, it would be advantageous to replace the existing coal fleet with wind plants, with natural gas plants, or with natural gas plants equipped with CCS. At a discount rate of 1 or 1.5 percent, solar photovoltaic and coal with CCS are also preferable to running the existing plants.

Interestingly, at the two lowest discount rates (2.5 and 3 percent) used in the government’s analysis, the real cost of maintaining the coal fleet is higher than replacing it with conventional natural gas plants. At its lowest rate (2.5 percent), wind and natural gas using CCS would also be economically efficient.

Generation costs of different technologies excluding pollution costs

Table 1 shows the cost of the seven generation technologies we examined, before adding any pollution costs.

For existing coal generation, we divided total operation and maintenance expenses of the entire fleet by its total generation. These expenses include only those needed for continued operation (e.g. fuel, labor, and maintenance).[3] They exclude future investments plants would be required to make in order to be in full compliance with new standards coming into effect in 2016 (for non-CO2 pollutants). To the extent that these costs are large (for plants without any control technologies they can be significant), we underestimate the cost of continued operation.

Generation costs for building new generation from cleaner sources

Table 2 shows new generation costs inclusive of CO2 and SO2 pollution damages, for four of the cleaner options versus coal and natural gas.[4] Carbon costs are based upon the estimated damages per ton of CO2 at the different discount rates, translated into cents/kWh of generation. It should be noted that the government applies different discount rates to SO2 damages than to CO2 damages[5]; nevertheless, SO2 damages are not noticeably affected by discounting because its impacts are more immediate.

Our revised estimates using 1.5 percent discount rate results in onshore wind and natural gas with carbon capture being more economically efficient than conventional natural gas (9.2 cents/kWh for wind and natural gas with capture (highlighted in blue), versus 10.9 cents/kWh for conventional natural gas (highlighted in yellow). At the 1 percent discount rate, all four of the cleaner technologies (onshore wind, solar photovoltaic, and natural gas or coal with carbon capture and storage) are cheaper (15.7, 14.9, 9.8, and 9.2 cents/kWh, versus 16.4 cents/kWh for natural gas). In contrast, when the government’s higher discount rates are used, natural gas appears to be cheaper than the cleaner sources.

While Table 2 compared four cleaner technologies to natural gas or coal for new generation sources, Table 3 compares five cleaner technologies to existing coal plants’ generation, adding natural gas as a cleaner option. Natural gas has CO2 emissions roughly half that of coal, and relatively small emissions of other pollutants. Again, it should be noted that the government applies different discount rates to SO2 damages than to CO2 damages[6]; SO2 damages are not noticeably affected by discounting because its impacts are more immediate.

Replacing the existing coal fleet with wind, natural gas, or natural gas with CCS is efficient at all of our discount rates (compare costs highlighted in pink to those in blue). Using a 1 or 1.5 percent discount rates, all five of the cleaner technologies are more economically efficient.

At the government’s 2.5 and 3 percent discount rates, new natural gas is cheaper than the existing fleet; at 2.5 percent natural gas with capture is also advantageous (and wind almost equal, at 9.2 vs 9.1 cents).

Methods, assumptions, and notes

1) Sources of SO2 damage estimates.­ SO2 damages/ton of new electricity generation were taken from a recent regulatory impact analysis by the Environmental Protection Agency for the Transport Rule, representing damages resulting from emissions additional to those from existing generation. SO2 costs for existing generation were estimated using a model developed by Abt Associates that employs the same fundamental process as that used by EPA, which has been approved by both the EPA’s Science Advisory Board and the National Academy of Sciences. The result presented here is the average derived from two widely-used estimates of the relationship between fine particle concentrations and health impacts (Pope and Laden), for emission levels that are assumed to be in compliance with new standards in 2016.

2) Excluded non-CO2 damages. We do not include EPA’s estimates of damages from nitrogen oxide (NOx), as we could not isolate NOx emissions attributable only to coal combustion, though these damages are far smaller than damages from SO2. In addition, a very large number of health and ecological damages are excluded from EPA’s estimates of SO2 and NOx emission damages (see Table 5-1 for a list of excluded human health effects, and Table 6-12 for ecological effects, in EPA’s benefit cost analysis of the Clean Air Act). They also exclude externalities other than air emissions from the power plants, such as methane emissions from natural gas wells and land disturbance from coal mining.

3) Excluded CO2 damages. The government’s model does not adequately capture: 1) potentially discontinuous “tipping point” behavior in Earth systems (e.g. a 20 foot rise in sea level that would result from a complete melting of either the West Antarctic or Greenland ice sheets, or other catastrophic risks); 2) inter-sectoral and inter-regional interactions, including global security impacts of high-end warming, and 3) the limited degree to which man-made capital can substitute for losses in “natural capital” (i.e. natural systems). Inter-sectoral and inter-regional impacts refer to interactions between events, where one type of climate damage can lead to, or exacerbate, another. For example, extreme weather events could lead to various public health damages (“inter-sectoral”) or mass migration, which in turn could lead to socio-political international conflicts (“inter-regional”). An example of substitutability would be whether agricultural innovations could substitute for damages to ecosystems that interfere with food production or, more trivially, whether increases in material consumption can compensate for the intrinsic value we place on preserving precious ecosystems, such as coral reefs or national forests.

4) Incorporation of pollution costs into the costs of electricity generation. Pollution damages were incorporated into electricity generation costs as follows: $damages/kWh = (total annual tons of emissions*$damage/ton)/total number of annual kilowatt hours), for a model 600 net megawatt (MW) power plant operating at an 85% capacity factor. For example, a model coal plant emits 3.6 million tons of CO2 per year and generates 4,467,600 kWhs of electricity (1.7 million tons of CO2 for a comparable natural gas plant). A carbon damage estimate of $35 per ton of CO2 thus generates 2.8 cents/kWh in pollution costs for a new coal plant, while damages of $65/ton of CO2 generates 5.2 cents/kWh in damages. For conventional coal, coal with CCS, and natural gas, we used model plants provided in EPA’s regulatory impact analysis (link) for proposed new carbon standards. For natural gas with CCS we used estimates based upon net generation of a model plant estimated by the Department of Energy.

5) Generation costs for existing coal. For our existing coal generation cost, we divided total operation and maintenance expenses of the entire 2010 fleet by total generation, using plant-specific data from SNL Financial. These expenses include only those needed for continued operation (e.g. fuel, labor, and maintenance). While it may cost less to continue running some of the cheapest coal plants than to replace them with cleaner generation, we were constrained to looking at the average costs of operating the entire coal fleet, because we did not attempt to predict future emission rates and operating costs at the individual plant level. For example, we did not assess the costs of replacing only the most expensive coal plants because we did not calculate their SO2 damages individually. Our estimate excludes future investments plants would be required to make in order to be in full compliance with new standards (for non-CO2 pollutants). To the extent that these costs are large (for plants without any control technologies they can be significant), we underestimate the cost of continued operation. A small fraction of costs that cannot be avoided even after a plant ceases operation are included in our measure, such as rental fees that must be paid until a lease expires. However, operation and maintenance cost, and purchases of emission allowances, account for the majority of costs associated with operation (plants that reduce pollution below standards can sell excess emission allowances, lowering their operation costs).

6) Overestimated costs for wind and solar. To the extent that the Energy Information Administration (EIA) overestimates wind and solar costs as it has in the past, costs for these technologies are overestimated. They are also likely to be overestimated because EIA assumes that all new generation would require new transmission rather than use of current lines.

Footnotes:

[1] While it may be cheaper to continue running some coal plants than to replace them with cleaner generation, we examined the average costs of operating the entire coal fleet, rather than attempting to predict future costs and emission rates at the individual plant level. Our costs for alternative generation sources are also on an average basis. See methods section at the end for more detail.

[2] Levelized cost represents the total cost of building and operating a generating plant over an assumed financial life and duty cycle, converted to equal annual payments and expressed in terms of real dollars that remove the impact of inflation. It includes overnight capital cost, fuel cost, fixed and variable operation and maintenance costs, financing costs, and an assumed utilization rate for each plant type. Various incentives including state or federal tax credits are not included.

[3] A small fraction of costs that cannot be avoided even after a plant ceases operation are included in this measure, such as rental fees that must be paid until a lease expires. However, operation and maintenance cost, and purchases of emission allowances, account for the majority of costs associated with operation (plants that reduce pollution below standards can sell excess emission allowances, lowering their operation costs).

[4] While the market has all but abandoned new coal generation, we include it here for completeness.

[5] Note that OMB guidelines specify two standard rates of 3 and 7 percent, regularly applied to benefits and costs that occur within the current generation. However, the government used 5 percent as its upper value rather than 7 percent for climate damages, for the reason that they are expected to primarily and directly affect consumption rather than the allocation of capital. A rate of 7 percent corresponds to returns on capital investments (see p. 33 of OMB Circular A-4 and our paper for further explanation).

[6] Note that OMB guidelines specify two standard rates of 3 and 7 percent, regularly applied to benefits and costs that occur within the current generation. However, the government used 5 percent as its upper value rather than 7 percent for climate damages, for the reason that they are expected to primarily and directly affect consumption rather than the allocation of capital. A rate of 7 percent corresponds to returns on capital investments (see p. 33 of OMB Circular A-4 and our paper for further explanation).

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